Diageo and MH "What If" Scenario

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FILED SEPTEMBER 1, 2009

Dear Client:

Speculation on Diageo making a bid for the remaining 66% stake in Moet Hennessy never completely subsided but was again brought to attention on Friday when Britain’s Daily Telegraph reported possible initial talks between MH and Hermes. In order to fund the supposed transaction, LVMH would have to sell its stake in MH. The Telegraph cites Paris-based brokers “who believe Bernard Arnault, the boss of LVMH, has made an approach for the fashion business Hermes. However, the approach is said to be conditional on LVMH obtaining financing from the sale of its wine and spirits division to Diageo.”

In response, UBS analyst Melissa Earlam published a report today on the impact such a deal would have on Diageo. The firm believes it would be a good move for Diageo as they would gain full ownership of important Cognac and Champagne brands, but acknowledges there are risks involved. “We continue to believe that a MH acquisition would be very attractive strategically for Diageo, but see risk surrounding the multiple that would be paid,” she said.

WHAT’S IN IT FOR DIAGEO?

Although Diageo already has exposure to Champagne and Cognac through its 34% stake in MH, UBS thinks Diageo would like to own the brands completely. For one, Diageo has to gain LVMH’s permission before purchasing other Champagne or Cognac brands, which is a hindrance since both categories “are attractive and deliver premium operating margins, in both cases above Diageo’s group margin.”

Not to mention that MH possesses market leading brands in Cognac and Champagne, with Hennessy owning 57% share of the US Cognac category and 36% market share globally, who wouldn’t want to own it? In Champagne, meanwhile, MH’s has about 18% market volume share of the global market with Moët Chandon and Veuve Clicquot taking the top two spots. Furthermore, UBS estimates that MH has 2% share of spirits market volumes in the US, which would add to Diageo’s 30.4%. The two companies conveniently operate through the same US wholesalers in most states, which would make brand transitions much simpler.

Fully acquiring MH would give Diageo more presence in markets such as France, Japan and rest of Asia, including China, where it’s currently not as strong as MH. UBS anticipates that the only anti-trust issues the possible deal could run into would be Glenmorangie single malt and Belvedere ultra premium vodka.

WHAT IS MH WORTH?

UBS values the 66% MH stake at about £11.6 billion (€12.6 billion), and believes it would be financed with 50% debt and 50% equity. “Given the superior quality of Moët Hennessy’s brands, and high scarcity value for Cognac and Champagne brands, we believe any acquisition of this portfolio is likely to be at an above average multiple.” LVMH has the right of first refusal to acquire Diageo’s 34% stake in MH at a 20% discount to market value, but this agreement does not work both ways for Diageo to acquire the remaining 66% stake. However, Diageo has pre-emption rights.

On this basis, Diageo’s net debt/EBITDA would increase to 3.0x in Year 1 and fall to 1.5x by Year 3, which UBS believes would “allow Diageo to return to ‘single A’ credit rating quickly.” UBS estimates a cost of debt of 6.5% compared to Diageo’s cost of debt of 6.2% for 2009 and 5.5% for fiscal 2010. They assume Diageo could realize cost savings equivalent to 2.5% of pro forma 2010 fiscal sales for wine and spirits. UBS also anticipates cost savings in overhead costs; sales and marketing costs; and distribution synergies (particularly in Europe).

“We do not believe that Diageo would need to invest in higher sales and marketing behind Moët Hennessy’s brands given the high level of advertising investment that management has been committed to,” states the report.

WORD FROM TOP EXECS

Although chief Paul Walsh has remained relatively silent on the rumors, he again reiterated Diageo’s interest in possibly acquiring all of MH. “We haven't built a strong balance sheet, to squander it on brands that are not truly strategic. We've always said if Cuervo became available, that would be of interest. And we've expressed our interest in Moët Hennessy. But equally, we will be disciplined,” he said in the company’s results August 28.

“I think that would very much lead us to say that for the right acquisition, if it required it, we probably would approach the shareholders and if it required it, ask for some equity, because that would go hand in hand with our view of maintaining that pretty strong financial credit rating,” said cfo Nick Rose.

TIPS AND PREDICTIONS ON WINE CONSOLIDATION

Speaking of acquisitions, Robert Nicholson, president of the International Wine Association, led a panel at the Wine Industry Financial Symposium on consolidation in the wine business titled “What is the Value of a Winery Business Today?” The industry has been hard hit by the recession that has led to a virtual stand-still in acquisitions, although things may start picking up in the near future. What should prospective buyers and sellers look for?

SMALLER DEALS ON THE HORIZON:

Before turning the floor over to his panelists, Robert said he “expects increases in industry consolidation and continued evolution of major global groups that are also in the liquor and wine business,” such as Diageo, Constellation, Gallo and Pernod Ricard. This includes both the new world and old world. His group also “thinks there’s going to be continue emergence of these sizable second tier companies,” such as Wine Group, Sutter Home in North America, Concha and San Pedro in South America, Yalumba and Delegats in Australia and Asia, GIV and Castel in Europe and Distell and DGB in South Africa.

“Brands and winery businesses with good cash flow that compete in a niche that can enhance a buyers’ portfolio will be interesting targets to strategic and financial buyers,” said Robert. “Underperformers will have difficulty selling in the current environment.”

He predicts that there will be fewer mega-acquisitions in the future as there will be less major opportunities and fewer buyers. There will be an increase in brand transactions with no hard assets and sales of estate wineries. He noted that financial and generational issues often drive the decision to sell in the wine industry, “although a number of prominent California winery deals that were expected to close have not closed in the last 12 months.” And finally, valuations of the past will not come back except for a limited number of uniquely positioned companies.

Robert notes that although M&A activity has slowed over the past 9 months, it will pick up eventually. Some transactions are in progress or are about to start, “with the development of new groups and continued consolidation of major groups.” Financial pressures may also prompt some small and medium-sized wineries to sell.

BILL FOLEY ON M&A OPPORTUNITIES:

Bill Foley, chairman of Foley Wine Group, has been on an acquisition tear over the past few years with 6 new acquisitions. Foley Family Wines’ portfolio now consists of about 500,000+ cases of wine in Santa Barbara (Firestone), Napa (Merus & Kuleto), Sonoma (Sebastiani), Washington (Three Rivers Winery) and New Zealand (Vavasour, Goldwater, Clifford Bay, Boatshed Bay, Dashwood and Redwood Pass).

“You’ve got to be careful what you buy, where you buy it....location, location, location. If you don’t focus on that and valuation you’ll end up upside down again,” he told the audience.

“The opportunities I’ve seen are from three areas: businesses are over-leveraged, they borrow too much money. Many people got in the wine business for the lifestyle and had no business here...winery needs at least 5,000 cases or over so you can do the brand building process.”

Secondly, he sees family situations creating M&A opportunities: “they are not getting along well and they need to sell. If you wait it out long enough you can end up with a decent value,” he said.

And finally, the recession has created a good opportunity as well. “Opportunities are getting better than worse because of the economy...you can chase good properties in Napa and Sonoma.”

With regards to New Zealand, Bill noted that many wineries are having trouble getting good distribution in the US “unless they’re owned by one of the big guys.” Those wineries are also dealing with a bumper crop and needed to gain access to the US market.

LOOKS FOR HARD ASSETS, ESTABLISHED BRANDS:

Bill said he looks for hard assets when considering properties, which includes vineyard assets and production facilities. He also buys “case goods no more than cost;” tries “to buy the little guy;” and try to make sure debt is never over 30% “so there’s never a risk.”

He said the brand is very important as well. “I’m done with buying distressed brands because there are a lot of good brands out there.”

Foley Wine Group has no plans to sell any brands “unless we get the right offer,” he said.

He told the audience that “I’m not a genius...I steal my ideas from Jess Jackson.” He noted that “I got into the wine business because I was a wine drinker, not a visionary of any sort.”

ON DISTRIBUTOR RELATIONS:

Bill said he always thought he could get more attention from distributors when he got to 100,000 cases. “Wrong, not even close,” he said, laughing. He noted that things are better at 500,000 cases but “we’re still not there.”

“You have to move cases from around the world...maybe then they’ll help us sell some wines,” he said, which was met with laughs. “Maybe we can get their attention and get on their radar screen or we’ll have to go somewhere where we are.”

WHY GESD ENTERED THE WINE INDUSTRY:

Next on the panel, Dan Stromberg, co-founder and partner at GESD Capital Partners, talked about his company’s involvement with Ascentia. Recall that after Constellation acquired Beam Global’s wine portfolio in 2007, it sold 7 of those brands to newly created Ascentia Wine Estates for $234 million. Ascentia is backed by private equity group GESD and WJ Deutsch & Sons.

Dan told the audience that GESD had “been looking at deals for 5 years before we got involved in Ascentia.”

“Wine deals are different,” he noted, “but we were interested in increasing consumption, changing demographics such as millennials, increasing sentiment that wine is healthy, and the industry’s resiliency.” He said it was also important that “there were fewer private equity firms competing in this market for that space.” Ultimately GESD plans on selling its stake to Deutsch or another interested partner. Establishing an “entrance and exit plan is important,” he said.

Dan believes “cautious optimism” is the future of the wine business, which is reflected by acquisitions.

VINCRAFT FOCUSES ON THE HIGH-END

Pete Scott, ceo of The Vincraft Group, says his company is most interested in the high-end sector of the industry. They recently acquired a majority interest in Kosta-Browne and will operate a small portfolio of ultra premium wineries. He noted that there is an “emerging fatigue factor of people who have been in the business for a long time to down-size.” The luxury category has also experienced “a brand specific phenomenon” with regards to softness. Some brands are doing well while others are inexplicably failing.

WSD BRIEF:

WINE DYNASTY BY MARRIAGE. Jean-Charles Boisset (of France’s third largest wine company) and Gina Gallo (of E&J Gallo) were married over the weekend in a private ceremony at the Fairmont Hotel’s penthouse suite. About 100 guests were in attendance. Jean-Charles is president of the US Boisset Family Estates, while Gina is head winemaker at Gallo Family Vineyards.

Until tomorrow, Megan

“Maturity is a bitter disappointment for which no remedy exists, unless laughter can be said to remedy anything.”Kurt Vonnegut

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